Basics of Fixed Income Instruments
When we deposit some amount in our Bank FD let’s say 1 lakh at 7% p.a. compounded quarterly, we know that at the end of the year we will get, 107186 (we’ll calculate this later in the module). This bank FD is nothing but an example of Fixed Income Instrument (FII).
Lets us break down this term.
Fixed here means the amount which we will receive and is already decided and we are aware of that amount. We are also aware of the time period after which we will receive that amount and it is also fixed income. Instrument means the model through which we are investing the principal.
Lets us understand the above example with the help of the definition.
We invested 1 Lakh in bank FD for 1 year at 7% p.a. compounded quarterly. As an investor, we are aware of all the things which are interest rate which we will get on our principal invested, time period after which we will get our amount (principal + interest) back and how much that amount will be.
We have used two words above, Principal and interest. Lets us define these terms.
The principal means the initial sum of money you have invested. In the above example, it would be 1 lakh. Interest means the money which is earned/generated by investing our principal. In the above example, 7186 is the Interest earned on our principal of 1 lakh.
Sum of Principal and Interest is nothing but Amount.
One should be very clear about these terms.
Types of FII’s
There are two different types of financial income instruments namely Government and Private which can be further classified as follows –
We will discuss about all the above instruments in detail in coming chapters. We’ll now look at pros and cons of FII, and the risk factors associated with FIIs.
Pros of FII
Constant Source of Income
One of the biggest advantages of FII is that it provides a constant income to investor and he can plan his budget accordingly. For example, if a person knows that at the end of every month he will receive 30 thousand, he can plan all his monetary decisions accordingly.
Right to Asset
In case the company goes bankrupt or declares insolvency, bond holders (FII Instrument) have the first right of receiving money than equity holders so their principal amount is relatively safe.
Price fluctuation is less in the bond market compared to the equity market and because of this it is considered a safe investment and preferred by people who do not want to take more risks.
When we have fixed income from equity instruments, we have to pay additional tax on it but that is not the case with FII rather it gives us lots of tax benefits and we can save a lot of money by investing in FII.
Diversification in the portfolio:
Equity products give huge returns but also have high risks and to diversify that risk we add FII to our portfolio so that risk is reduced and we get stable returns from our portfolio.
Cons of FII
FII is less risky when compared to equity and that is why they give less return and because of this many people do not invest in FII. Risk and return go hand in hand higher the risk, higher the returns and vice-versa. It depends on the investor’s risk appetite that how much risk he wants to take.
Equity gives you the freedom of withdrawing money whenever we want to. But the same is not the case with FIIs. Different FIIs have a different lock-in period and if we withdraw before that, we have to pay a certain amount as a penalty for premature closer/withdrawal.
Risks associated with FII
The following are the risks that FIIs instruments are exposed to and which investors should be well aware of and try to minimize it by gathering more and more information.
Interest rate risk
For example, we invested 20 lakh in bank FD at a 7% rate for 1 year. But after the recent RBI policy, the bank reduced the interest rate with immediate effect. So now instead of 7% we will earn let’s say 6%. This reduction of 1% is nothing but interest rate risk. Change in the value of the Amount due to a change in the absolute level of Interest Rate.
Liquidity risk means that an investor is not able to sell his instrument in the market because of the thin size of the market. If you want to sell a bond and there are no buyers, two things would happen either you will hold the bond and wait for the new buyers or book a loss and sell the bond at a lower price. This leads to huge price fluctuations.
Suppose for example we invested in an instrument with 5% p.a. but during the same period inflation rate increased by 4% so now our actual return on investment is only 1% because rest 4% got reduced due to inflation. Sometimes because of inflation we can have negative returns also.
Credit Default risk
Suppose for example we invested 10 lakh in Reliance communication 9% bonds for 10 years. Now for instance Reliance communications goes bankrupt. In this case we might receive our full money or might receive partial payment or might not receive money at all. This risk is called credit Default Risk.
Credit Rating Agency
These are firms which check the credit worthiness of the issuer company and rate their bonds accordingly. Higher the ratings better the company and safer the investors. They have to get registered under SEBI to function in India. Currently in India there are 6 rating agencies namely CRISIL, CARE, ICRA, SMERA, ONICRA, FITCH.
Before investing in any FII, one should check for the rating given to the instruments. These agencies do very deep research about the companies and environment in which they are operating and they give rating accordingly.
Information from ATS
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